California Revenue and Tax Code §23101

The Issue

With more and more companies forgoing brick and mortar by operating their business through the internet, tax authorities find it increasingly difficult to determine which enterprises are subject to state income taxes and which aren’t. Typically, California has taken an aggressive stance. In 2011, it passed a new law that defined “doing business” in California beyond being physically present by having offices or operations. Instead California sought to define what constituted an “economic nexus” to the state, using factors such as sales, payroll, and inventory. In 2013, comprehensive regulations went into effect casting a broad net over the activities of out-of-state corporations and pass-through entities (LLCs, partnerships, S corporations) as doing business in California. Judicial decisions interpreting those rules are just starting to trickle in. The picture that is emerging indicates that non-California internet businesses need to be wary or they may find themselves subject to California taxation.

Why Does It Matter Whether Your Company Is “Doing Business” in California Or Not?

First, why does it matter if California determines an internet company is “doing business” in California? It may matter a great deal. The determination that an out-of-state entity is doing business in California is one of the ways California can impose income taxes on that business, even if they have no physical presence in California (the other is based on the entity earning California-source income). In some cases, there may be a tax liability even if the company made zero income from California sales.

It’s no trick to leave California to avoid its high income taxes – if that’s all you want to do. But in fact, most people who change their legal residency from California have more in mind. They also want to retain contacts with the state. That might mean a vacation home, it might be managing a California business remotely, it might involve meeting potential clients or investors in California for an out-of-state entity. The last situation, which is fairly common, requires planning, since changing residency may not be enough to avoid California income taxes if your work for your out-of-state business brings you back to California.

When Changing Residency Isn’t Enough

A typical situation involves a business owner who changes legal residency and moves his business out of state. Well and good. Unless a taxpayer changes legal residency, everything else is moot from a tax perspective, and if the company operates out of California, distributions to its out-of-state owner are also subject to California tax. But the fact is California is an economic powerhouse. Few businesses, especially those in high-tech and financial services (which are increasingly the same thing), can succeed without participating in the California market. And that often means meeting with and cultivating potential clients or investors in Los Angeles or Silicon Valley, where the capital, expertise and demand resides.

If that’s the case, it’s important to understand the differences between personal residency as opposed to doing business in California versus working while present in California. These are three separate tax issues, which require different approaches to manage. Continue reading

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